Earlier in September, the United States Federal Reserve took it upon themselves to undergo a third round of quantitative easing. This is part of an initiative and worldwide effort to bring our struggling economy back onto firmer soil. Investors have mainly been looking for a safe haven such as gold, which is something that often happens while there is so much economic uncertainty. It’s true that the Fed has promised to avoid inflation, but what happens if they can’t fulfill on that promise?
In Warren Buffett’s book, The Essays of Warren Buffett: Lessons for America, Mister Buffett spends a lot of time talking about investing throughout an environment that is riddled with inflation. In the book, the main idea is between weighing economic goodwill versus accounting, and high return on investment, light asset businesses versus lower return on investment, hard asset businesses.
A way to describe economic goodwill is when a business can use their net tangible assets as a way to create a tremendous rate of return, then the premium value provided by the net tangibles is said goodwill.
Accounting goodwill is when a business is purchased at a price that is actually higher than its net asset value. To put it simply, true economic goodwill doesn’t disappear over time, but it actually nominally rises right along with the rate of inflation.
We learn in popular investing that good investments during an environment of inflation would be capital-intensive businesses. But Warren Buffett has a much different view on an inflationary environment. He prefers to stick with asset light businesses, but they have to have high economic goodwill. This is his idea of a far better investment.
He believes this for very interesting reasons. First, the businesses that are heavy with assets must constantly reinvest in order to keep their sales figures high and hold onto their market position. Second, as prices go up for inflationary reasons, any advantage that higher sales prices bring will probably be negated because of the high rising costs associated with bigger capital spending.
If we play devil’s advocate for a minute, the businesses that are asset light are much less capital-intensive. Because of this, these businesses are capable of investing much less, but they are still going to keep their position during an environment that is filled with inflation. Plus, this type of business will be able to raise their prices on the consumer market, so it has the possibility of earning more money for each and every dollar that the company invests.
It’s important that you realize that this style of business actually appears to be more expensive when you compare it to a low ROI, heavy asset business. But as the logic of Warren Buffett shows us, these businesses are truly worth more, and the value of this type of company will only grow during an environment of inflation.
It’s also possible for you to figure out the after-tax return on tangible capital if you use a mathematical formula to figure out if one of these businesses will be a good hedge for inflation. So use this mathematical equation and apply it to the economic circumstances of certain businesses that you’re interested in, and invest in that company if it fits the specific criteria needed to thrive in an inflationary environment.